Over the years, stock market analysts have noted a pattern that has come to be known as the “January effect” — a pronounced uptick in prices during the first two or three weeks of the year. Tax-savvy investors, so some theorize, sell off struggling stocks at the end of the year as write-offs, and those stocks rebound after the calendar flips, kindling at least temporary optimism in the market.
This year, we got a different kind of January effect. Three weeks into 2016, the Dow was already down 9.5% for the year. All told, investors pulled $25.6 billion out of U.S. stock funds, and 40% of stocks listed on the New York Stock Exchange hit 52-week lows.
Given that kind of a rocky start to the new year, what should investors do? Hide their money under mattresses? Go against the crowd and look for bargains? Or just ignore the financial news and hope things turn around?
How Did We Get Here?
When the market seems to be going a little nuts, it can be helpful to take a step back and look at the history of the market. Ups and downs — some of them relatively mild, others sharper “corrections” where the market loses 10% of its value — are par for the course. Even in the midst of the longest bull market in U.S. history (a 17-year period between 1982 and 1999 when the Dow increased ten-fold) we had October 19, 1987: Black Monday, when the Dow fell just over 22%, still its largest single day loss.
The new century has seen two big crashes: the first in early 2000 when the dot-com bubble burst, and the second in 2008 following the sub-prime mortgage crisis. In 2009, the stock market bounced back — tentatively at first, but then with gusto in 2014 especially.
Last August, China devalued the yuan — raising concerns about the health of the world’s second-largest economy, and also about a possible currency war — and stocks dropped sharply. The market rallied during the final three months of the year, but never fully restored its previous gains. Stocks began falling the last two days of 2015, got off to a record worst four-day start to a year, and basically didn’t stop until January 20, when the market fell just short of hitting last August’s low.
If there’s anything unusual about the current unrest in the market, it’s that we’ve gone almost six years without a downward correction.
Dark Clouds on the Horizon
What’s got traders so jittery?
China remains a concern. It has continued to devalue the yuan in an effort to stimulate its stalled economy. Its own stock market began the year in full melt-down mode, with regulators having to suspend trading twice in order to prevent full-blown panic. Observers worry about a “crash landing” for China’s economy.
Crude oil prices have hit a 12-year low. Falling prices at the pump seem like a good thing, and should theoretically lead to increased consumer spending. But the oil and gas industry is a bigger part of the American economy than it used to be (its share of Gross Domestic Product is double what it was ten years ago), and the woes of the energy sector have helped pulled down the rest of the market. More generally, when oil prices drop this low, it is seen as a sign of a weak global economy.
The global mood is somber on other fronts. There’s China. Other once promising emerging markets like Brazil have fallen on tough times. The IMF’s updated World Economic Outlook report for 2016 is discouragingly titled Subdued Demand, Diminished Prospects. And political concerns from Syria and Iran to the refugee crisis and the threat of terrorism further dampen global outlook.
Yet it is concerns closer to home that really have the U.S. stock market singing the blues. When the Federal Reserve raised its so-called “target rate” last December (part of a broader pulling back of economic stimulus measures implemented after the economic crisis of 2007–2009), it was seen as a vote of confidence in America’s economy. But despite the fact that unemployment remains low and job growth is steady, wages are stagnant, and December marked the third straight month that manufacturing was down. Given those numbers, the Fed in mid-January downgraded its predictions for overall growth in 2016.
Bull or Bear?
How you approach your investing decisions this year depends to a large extent on your general read of where the market is at. While most experts advise against trying to “time” the market by predicting short-term price fluctuations, it can be a good idea to take the overall pulse of the market. Investment strategies that are fine in an upward bull market might not work in a stagnant bear market.
So where are we now?
Opinion is all over the map. Perennial optimist Jeremy Siegel of The Wharton School sees a silver lining in the choppy start to the year, and argues that there are bargains to be had in a volatile market, even if investors might have to wait a few years for those bets to pay off. His relative optimism springs from an assumption that we are not headed toward a recession, and that the global situation could soon stabilize with, perhaps, oil bouncing back to $40 a barrel, or the economy in China improving.
Lead economists at J.P. Morgan, however, warn that the risk of a recession in the next two to three years has “increased materially.” Contrarian investor Mark Faber contends that we’re already in a recession, and that the Fed is running out of bullets for artificially stimulating the economy. Seth Klarman of the Baupost Group looks back on 2015 as a “stealth bear” market, pointing out that the 23% gains amongst the top 10 of the S&P 500 made the stock market look better than it actually was.
Fear and Greed
Researchers in the growing field of “behavioral economics” argue that, especially in the short term, the market is far more irrational than classical economic models might indicate. Fear and greed are the north and south poles of such unreason.
When the market is riding high, investors “chase performance” and attempt to ride the coattails of trendy stocks and mutual funds (forgetting or ignoring the omnipresent disclaimer, Past performance is no guarantee of future results). In other words, they get greedy and worry about keeping up with the (Dow) Joneses.
When the market dips or is in free fall, investors get nervous and fearful, and sometimes bail out on solid investments, forgetting that losses are only paper losses until you actually sell. Wise investors keep their cool, and aren’t afraid of going against the crowd. As Warren Buffett famously advised, “Be fearful when others are greedy, and be greedy when others are fearful.”
CNN Money actually aggregates seven indicators into a Fear & Greed Index. At the low end is Extreme Fear, which should indicate an under-valued market and opportunities for brave bargain-hunters. At the opposite end is Extreme Greed, an over-valued market, and possibly a bubble waiting to burst. At the end of last year, the index stood steady at a neutral 47. Three weeks into 2016? A fearful 13.
Stay the Course?
Traditionally, advisors have urged investors to adopt a “buy and hold” approach: buy solid stocks or mutual funds, and then wait out the inevitable ups and downs of the market and try to capture your share of its long-term upward trend. Many also promote “auto-pilot” systems that involve regular, planned contributions to a retirement fund, regardless of whether the market is up or down.
One of the prime objectives of such a course, and of the traditionally well-diversified portfolio, is to take emotion and impulse (i.e., fear and greed) out of the equation. To try to ride the market, not beat it.
All of this is well and good — especially eliminating impulse decisions and, in effect, saving investors from themselves. Despite the well-worn adage to “buy low and sell high,” studies show that, far too often, investors do just the opposite.
But in an extended down market or, worse, a financial crisis, a classically diversified portfolio, however “conservative” it is advertised as, will leave you vulnerable to substantial loss of wealth. During the so-called “Lost Decade” of 2000–2010, for instance, bonds and even cash outperformed the S&P 500.
Another important factor is what investment professionals call your investment horizon: what are your investment goals, and when will you need the money? If you’re in your twenties and saving primarily for retirement, you can afford to wait out some bumps in the road, and riding the market with a diverse mix of index funds might make sense. But if you’re approaching retirement, or need your investments to fund significant short-term goals, hedging against a possible downturn with a portfolio weighted more toward fixed-income investments might be a wiser course. Although cash is never sexy, it does protect you against loss of capital.
Cash can also provide you with what investment insiders call “dry powder” — liquid cash reserves that allow you to jump in when the market has overreacted and prices have hit rock bottom.
The Road Ahead
As any good advisor will tell you, there’s no “one size fits all” investment strategy. So much depends on your goals, when those goals come due, and how much volatility you can stand in the meantime. Risk tolerance also stems from personal temperament. You want investments that allow you to sleep at night. Not everyone is comfortable betting on a bargain stock that the market seems to have given up on.
Whatever your investment goals and temperament, and however you read the market, remember that the worst investment decisions are made at the extremes: when the market is up and greed is dominant, or when it is down and fear rules. Check your ego, accept that no one can predict the market, and look skeptically on those who do. Don’t get caught up in the daily chatter of the financial press. Stay focused on the big picture.
Legendary investor Ben Graham was fond of saying that, while in the long run the market is a weighing machine that reflects underlying value, in the short run it is often a voting machine reflecting mood and public perception.
In this uncertain and unpredictable election year, the verdict of that voting machine remains to be seen.